Principal investor

Fund family CEO encourages focus on gains, not taxes

DALLAS (CBS.MW) -- For someone who runs a boutique mutual fund company called Undiscovered Managers, Mark Hurley has a lot figured out already about what individual investors need and what they don't.

Investors, Hurley says, need smart, consistent money managers on their side instead of the gimmicks and gizmos the fund industry foists upon them. They need funds that generate capital gains and cash flow and should not worry so much about taxes. Above all, they need to protect principal with a diversified investment portfolio spread over unusual and alternative directions.

Hurley is rarely without strong opinions. He clearly enjoys rattling the fund industry's cages with pointed research papers about the myths of mutual fund tax-efficiency and the increasingly Darwinian nature of the investment business.

The CEO's frank, forthright style is reflected among the seven no-load funds in the Dallas, Tex.-based family. Undiscovered Managers offers standards such as Small Cap Value,
USVRX
Mid Cap Value
UHVLX
and Small Cap Growth
USRLX
But the group also features more eclectic fare: Small Cap Special
USSLX
which delves into troubled companies; Behavioral Value
UBVLX, +1.17%
and Behavioral Growth
UBRRX
which use investor psychology in their stock appraisals, and a well-regarded portfolio
URTLX, +0.44%
that buys real estate investment trusts, or REITs.

On Wednesday, Hurley spoke with CBS MarketWatch.com about investment gains, losses and taxes. An edited version of that conversation follows:

MKTW: The bear market for U.S. stocks will soon enter its fourth year, and many investors are seeking alternatives. What can you tell them?

Hurley: We've gone from a period where, when you thought about returns, you almost entirely thought about capital gains -- hence the obsession with taxes. Today you don't expect price-earnings multiples to go up anytime soon. So the real question is Where will returns in the future come from? From cash flow, that's where. That's making people rethink assumptions that had worked for them.

MKTW: When stocks offer little or no appreciation, income is king - especially for people in or near retirement.

Hurley: There's been this idea that you should take a long view of investing and focus on capital appreciation. You could leave the equity portion of your portfolio largely untouched and just try to maximize the gains. And until recently a retiree had the luxury of getting a fair amount of cash flow from fixed income. But the prospect for capital gains is not that great, so trying to find investments that produce cash flow is now attracting a lot of attention. Racing into real estate investment trusts has been part of that.

MKTW: Some alternative investments seem even more risky than stocks and bonds.

Hurley: Sure, if people don't understand them. Knowledge is good. The benefits from traditional diversification have declined substantially. Investors want asset classes that are non-correlated with traditional asset classes and offer cash flow. REITs remain attractive because they return capital to you every year. People are also looking at gas and oil trusts, timber -- alternative instruments that produce a regular, predictable cash flow. While these instruments have principal risk, they should do okay on the income side.

MKTW: You've long argued that tax considerations shouldn't lead investment decisions. While taxes are the price of investment success, why knock a fund for trying to maximize gains however it can?

Hurley: Any mutual fund that describes itself as tax efficient -- that's like jumbo shrimp. What controls the timing of taxes is when people go in and out of the fund. If everybody leaves the fund, you've got a tax bill to pay. If people keep coming in you can defer the tax bill for a long period. That's true of actively managed and index funds.

The question to ask is: Where you are in the life cycle of a fund? Depending on when you get into the fund, that timing can be worth a fair amount of money. With funds that have embedded losses, you can inherit some of those losses. Trouble is, some of these funds might not have any offsetting gains for a long time.

MKTW: So investors should be grateful for a tax bill?

Hurley: Taxes within this context remain important. The first thing is not to worry about taxes but to pick good managers. Funds that don't have capital losses have cash flow. Those are the ones I want to buy. There are worse things than paying taxes, like losing your money. Protect principal first. If you really want to save on taxes, move to a state that doesn't have a state income tax.

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